What Makes a Strong Security Package in an LBO?
By Alfonso Vilaboa and Anika Keuning of Miller Shah LLP
Leveraged buyouts (“LBOs”) rely heavily on debt financing. Because of this, at the heart of any LBO lies an inherent tension between the sponsor and the lenders. The transaction itself is predicated on the sponsor’s financial projections for the target company over the holding period. If these assumptions prove overly optimistic or inaccurate, the result can leave the target company overleveraged and unable to meet its debt obligations (including the leverage the sponsor assumed to conduct the acquisition). Sponsors are motivated to maximize returns by deploying as much leverage as a company can sustain in order to maximize returns. Lenders, by contrast, look to temper this risk. Unlike sponsors, lenders generally do not benefit from the increased equity value and/or increased multiples once the investment is exited. Instead, their primary concerns involve ensuring the repayment of the debt. Balancing these competing interests is vital to the structuring of a successful LBO.
Enter a “security package,” the mechanism by which lenders safeguard their interest in a project, and a key mechanism in reconciling the tension at the heart of an LBO. Security packages act as a backstop, a “last line of defense,” for lenders. A “strong” security package can mean the difference between meaningful recovery and steep losses when an LBO company faces distress and acts as a compromise between a sponsor’s pursuit of higher returns and a sponsor’s need for downside protection.
What is a Security Package?
In a typical LBO, the target company’s assets act as collateral for financing. Lenders look for assurance that, if the borrower defaults, they can enforce that collateral and maximize recovery. A security package, a collection of agreements granting lenders security interests in the operating company, acts as a bundle of rights providing legal protection and recourse for lenders in an LBO.
But not all security packages are created equally. While some provide broad, enforceable rights for the company and its subsidiaries, others can leave gaps that sponsors, and other creditors can exploit.
For sponsors, the design of a security package can affect the structure and flexibility of the deal’s financing, while for lenders, it defines the scope of protection if the company encounters financial troubles. A strong security package also establishes the priorities of other creditors, mitigating potential disputes in the event of default. For deal professionals and counsel, understanding what makes a security package “strong” is vital to balancing this flexibility for sponsors with protections for lenders.
Key Features of a Strong Security Package
Collateral
A strong security package begins with a first-priority lien on substantially all of the company’s assets, both tangible and intangible. These may include real estate, equipment, inventory, accounts receivable, and intellectual property. This lien grants lenders the legal right to seize and sell those assets in the event that the borrower defaults. The first-priority lien becomes important in the face of other creditors. The anchor of any strong security package, collateral reduces the lender’s risk and lays out a path to recovery.
Guarantees
Strong security packages also include both upstream and downstream guarantees from the company’s subsidiaries or parent company. In an LBO, the borrower is often a holding company with limited assets of its own. Guarantees, therefore, ensure that lenders have direct recourse to the subsidiaries or parent company that own the assets and are generating cash flow. By extending this liability across the corporate group, guarantees reduce the risk of structural subordination while also increasing the pool of assets available for recovery beyond the holding company itself, in turn strengthening lender protection.
Perfection and Priority
A strong security package relies on properly perfected security interests, which ensure that the lender’s security interest is legally enforceable against third parties. This is accomplished through filings such as form UCC-1s for personal property or mortgages for real estate. Priority establishes the order in which creditors are entitled to recover the collateral in the event of default. Without perfection, a lien may be unenforceable against competing claimants, and without priority, a perfected lien may still fall behind other security interests. Together, perfection and priority provide the foundation for a lender’s ability to assert its right to the claim, making them essential components of a strong security package.
Covenants
Covenants are contractual obligations built into loan agreements that borrowers are required to comply with. They are meant to be guardrails to for the target company’s financial and operational performance, so that the lenders have comfort in the way the investment is being run. Naturally, the guardrails are there to help align the target company’s performance with the sponsor’s projections (which are the basis for the profitability of the deal).
Hence, breaching these covenants can expose borrowers to defaulting on the loan, thus allowing the lenders to foreclose the assets that comprise the security package. Covenants can be affirmative, requiring actions such as maintaining insurance or providing regular financial reporting, or negative, restricting activities like taking on additional debt. While lenders prioritize the preservation of cash flows, seeking to keep as much liquidity as possible within the operating company, sponsors desire operational agility in order to maximize profits. Covenants mediate this push and pull. They restrict the sponsor’s ability to take on unnecessary additional risk, while still allowing for the flexibility to ultimately repay the debt. Thus, covenants serve as a key component in managing risk in an LBO.
Attorneys focused on corporate and business transactions often assist sponsors and lenders in structuring covenants to strike the right balance between flexibility and protection.
Conclusion
In an LBO, leverage is inevitable. It is there in the name. But the strength of the security package determines how risk is allocated between sponsors and lenders. A strong security package, including effective covenants, is critical for mitigating the risks associated with debt financing.